Early Payment Discounts
Early payment discounts, also known as cash discounts or prompt payment discounts, are reductions in invoice price given to a buyer if payment is made within a specified period. They are a form of sales discount that incentivize prompt payment and help sellers improve their cash flow and reduce credit risk.
Early payment discounts are often expressed in specific terms, such as “2/10, net 30”. This means the buyer can take a 2% discount if they pay within 10 days; otherwise, the full (net) amount is due within 30 days.
For example, if an invoice was for $1,000 and the terms were “2/10, net 30”, the buyer could pay just $980 if they pay within 10 days. If they choose not to take the discount, they would pay the full $1,000 but have until the 30th day to make the payment.
These discounts can benefit both the seller and the buyer. The seller benefits from improved cash flow and a reduced risk of bad debt, while the buyer benefits from a lower cost. However, from the buyer’s perspective, it’s important to consider the cost of capital – if the cost of capital is higher than the discount rate, it might be better to keep the cash for other uses and pay the full invoice amount at the due date.
Example of Early Payment Discounts
Let’s say we have a business, Company A, that purchases supplies from Vendor B. Vendor B sends Company A an invoice for $1,000 with terms of “2/10, net 30”.
This means that Company A has 30 days to pay the full amount of the invoice ($1,000). However, if Company A can pay within 10 days, they’re eligible for a 2% discount.
Here’s how it works:
If Company A pays the invoice within 10 days, they calculate their discount as follows: $1,000 * 0.02 (2%) = $20. So, instead of paying $1,000, Company A would pay $980 ($1,000 – $20).
If Company A chooses not to take the discount, they must pay the full invoice amount of $1,000, but they have up until the 30th day to make the payment.
In this example, Company A can save money by paying early, while Vendor B benefits from receiving the payment sooner, which improves their cash flow and reduces the risk that Company A could default on the payment.
